The New World Economy

 The world economy has become

increasingly interconnected:
 Globalization: markets exceed national
boundaries; increased mobility of workers,
products, and information.
 Integration: people of different countries choose
to function jointly in governance, economic
interests, currency, etc.
 Developments
 The possibility of such a global economy has been
brought about by:
 Collapse of communism
 Lower transportation costs
 Advances in telecommunications (internet, etc.) related
technological innovations
 Economic need
 These have led to reductions in trade barriers
 General barriers
 Integration and free trade zones—Europe, North America, etc.
 The relaxation of bank and capital market regulations
 Top 20 Globalized Nations
Rank Nation Rank Nation
1 Ireland 11 United States
2 Switzerland 12 France
3 Sweden 13 Norway
4 Singapore 14 Portugal
5 Netherlands 15 Czech Republic
6 Denmark 16 New Zealand
7 Canada 17 Germany
8 Austria 18 Malaysia
9 United Kingdom 19 Israel
10 Finland 20 Spain
Source: Foreign Policy
 Sectors
 Economists typically separate the production
and sale of goods and services from the
exchanges of financial assets.
 Real Sector: production and sale of goods and
services.
 Financial Sector: transactions in global, foreign, or
domestic financial assets.
 Measurement is difficult because trade may
include services (invisibles) and electronic
commerce.
 Balance of Payments
 A record of international transactions
between residents of one country and the rest
of the world
 International transactions include exchanges
of goods, services or assets
 “Residents” means businesses, individuals
and government agencies, including citizens
temporarily living abroad but excluding
local subsidiaries of foreign corporations
 Double-entry Accounting in the BOP
 All transactions are either debit or credit
transactions
 Credit transactions result in receipt of payment
from foreigners
 Merchandise exports (valued f.o.b.)
 Transportation and travel receipts
 Income received from investments abroad
 Gifts received from foreign residents
 Aid received from foreign governments
 Double-entry Accounting (Cont’d)
 Debit transactions involve to payments to foreigners
 Merchandise imports
 Transportation and travel expenditures
 Income paid on investments of foreigners
 Gifts to foreign residents
 Aid given by home government
 Overseas investments by home country residents
 Each credit transaction has a balancing debit
transaction, and vice versa, so the overall balance of
payments is always in balance.
 Accounts Overview (Level 1)
 Current Account (all real transfers)
 Merchandise trade
 Service trade
 Transfers
 Capital and Financial Account (transfers of
ownership and financial assets and liabilities)
 Changes in private assets
 Changes in holdings of official international reserves
 Statistical Discrepancy
 Current Account
 The current account is that balance of payments
account in which all short-term flows of
payments are listed:
 Goods and services balance (exports – imports)
 Merchandise trade balance (exports – imports)
 Services balance (exports – imports)
 Net Investment income
 Unilateral transfers
 Private transfer payments
 Governmental transfers
 What are Services?
 Travel and tourism
 Trade transportation
 Insurance
 Education
 Financial, technical, and marketing services
 Telecommunication
 Use of property rights (royalties)
 Other professional and consulting services
 What is Investment Income?
 Payment to holders of foreign financial
assets, including:
 Interest on bonds and loans
 Dividends and other claims on profits by
owners of foreign businesses
 Payments made to temporary (nonresident)
workers
 Unilateral Transfers
 Official government grants in aid to foreign
governments
 Charitable giving (e.g., famine relief)
 Migrant workers transfers to families in their
home countries
 Capital Account
 The capital and financial account is that balance of
payments account in which all cross-border
transactions involving financial assets are listed.
This includes transactions between foreign and
domestic residents, and foreign and domestic
governments.
 All purchases or sales of assets, including:
 Direct investment
 Securities (debt)
 Bank claims and liabilities
 Official reserves transactions
 When U.S. citizens buy foreign securities or when foreigners
buy U.S. securities, they are listed here as outflows and inflows,
respectively.
 Foreign Direct Investment (FDI)
 Any flow of lending to, or purchases of ownership in, a
foreign enterprise that is largely owned by residents of the
investing country.
 Securities (stocks and bonds)
 Loans
 Bank deposits
 Minority ownership positions
 FDI is the purchase of assets to establish financial control of a
foreign entity. Generally ownership of 10% or more of a
company’s outstanding stock is considered FDI.
 Portfolio investment involves little management control or
interest, and is solely for financial gain.
 Official Reserve Assets
 Early on in this century, this was primarily gold
 Now primarily financial assets denominated in
a foreign currency that is widely accepted in
international transactions:
 Euro assets (heavily used by U.S.)
 Yen assets (heavily used by U.S.)
 U.S. dollar assets (key currency worldwide)
 Reserve positions in IMF
 SDRs (created by IMF)
 Official Reserves Transactions
 Governments can influence exchange rates by buying
and selling official reserves.
 The buying and selling of official reserves is
recorded in the “official transactions” account.
 Also referred to as “changes in holdings of official
international reserves” or “official settlements balance”.
 It is the part of the balance of payments accounts that
records the amount of its own currency or foreign
currencies that a nation buys or sells.
 Statistical Discrepancy?
 It is the net result of errors and omissions on
both the credit and debit sides.
 Where do these errors come from?
 Under-reporting merchandise imports
 Under-reporting investment incomes
 Under-reporting capital exports
 Basically, people succeed in hiding their imports,
foreign investment incomes, capital flight from
their governments for tax and other purposes.
 Account Overview (Level 2)
Current Account Capital Account
Merchandise trade Changes in US assets abroad, net
exports other US govt assets
imports US private assets
Trade Balance All changes, net
Services
Changes in foreign assets in the US,
military trans. (net)
other services, net net foreign private assets
Service Balance All changes, net
Balance on goods & services
Investment income, net
Unilateral transfers
Changes in holdings of official
US government grants international reserves, net
US govt pensions, and
other transfers
Private remittances and
Statistical discrepancy
other transfers
All transfers, net Balance on capital account
Balance on current account
 Current Account
 The difference between the import and
export of goods is sometimes called the
balance of merchandise trade.
 Although the popular press often uses this
measure, the merchandise trade balance is not a
good summary because services are an important
component of trade.
 The balance on goods and services includes
trade in services. This includes visible and
invisible trade .
 Current Account, 1970-2002
200

100

-100

-200

-300
Current Account
-400
Goods
-500 Services

-600
1970 1975 1980 1985 1990 1995 2000
 Current Account Surplus and Deficit
 A current account surplus means exports of
goods and services, investment income and
transfers exceed imports and outflows.
 A current account deficit means imports of
goods and services, and outflows are
greater than exports and inflows; must be
financed by borrowing (capital account
inflows).
 Linkage to NIPA and
the Domestic Economy
 Current Account (CA) surplus equals net
foreign investment (If ). CA = If .
 If If > 0, the country has net foreign investment, so
the country must be investing part of its saving
abroad, and S = Id + If .
 That means If = S – Id .
 Recall that Y = C + Id + G + (X – M).
 Also, CA = X – M.
 Domestic Expenditures E = C + Id + G, and
Y – E = X – M = CA
 C + Id + G is sometimes referred to as absorption.
 Meaning of Overall Balance
 The current account and the capital account measure
the private and non-U.S. government supply of and
demand for dollars.
 Official Settlements Balance:
B = CA + KA
 Because the balance of payments must sum to zero,
any imbalance in the official settlements balance
must be financed (paid for) by official reserves
flows:
B + OR = 0
 BOP Surplus and Deficit
 The Official Settlements Balance (B ) is sometimes
referred to as the net sum of the items above the
line or autonomous transactions, and
 The Official Reserves Transactions (OR ) are
referred to as the sum of the items below the line,
also called nonautonomous or accommodating
transactions.
 When B = 0, there is said to be a BOP equilibrium, and if
B  0, a BOP disequilibrium.
 When B > 0, there is said to be a BOP surplus.
 When B < 0, there is said to be a BOP deficit.
 BOP Surplus and Deficit (Continued)
 In terms of the supply and demand of a
nation’s currency, there is:
 A balance of payments surplus if quantity
demanded for a currency exceeds quantity
supplied, putting upward pressure on the value of
the nation’s currency.
 A balance of payments deficit if quantity
supplied of a currency exceeds quantity
demanded, putting downward pressure on the
value of the nation’s currency.
 Official Transactions Account
 Most of the Official Reserves flows are official
interventions by the country’s monetary authorities
in the foreign exchange markets.
 When a government buys its own currency to hold
up the currency’s price, we say that the government
has supported its currency.
 It is holding the exchange rate higher than that rate otherwise would
have been.
 When it sells its currency, it is attempting to depress
the value of its currency.
 It is forcing the exchange rate to be lower than that rate would
otherwise have been.
 Official Transactions Account
 Because they are an accounting identity, the
current, capital, and official transactions
accounts must sum to zero—in total, the
balance of payments balances.
 The supply of currency, including
government’s, must equal the demand for
currency, including government’s.
1999 Balance of Payments Accounts
1999 Balance of Payments Accounts
 BEA International Transactions Data
May 19, 2003, U.S. International Transactions (Millions)
Line (Credits +; debits -)/1/ 2000 2001 2002/p/
Current account
1 Exports of goods and services and income receipts 1,417,236 1,281,793 1,216,504
2 Exports of goods and services 1,064,239 998,022 971,864
3 Goods, balance of payments basis/2/ 771,994 718,762 682,586
4 Services/3/ 292,245 279,260 289,278
12 Income receipts 352,997 283,771 244,640
13 Income receipts on U.S.-owned assets abroad 350,656 281,389 242,177
14 Direct investment receipts 149,677 125,996 128,068
15 Other private receipts 197,133 151,832 110,766
16 U.S. Government receipts 3,846 3,561 3,343
17 Compensation of employees 2,341 2,382 2,463
18 Imports of goods and services and income payments (1,774,135) (1,625,701) (1,663,908)
19 Imports of goods and services (1,442,920) (1,356,312) (1,407,406)
20 Goods, balance of payments basis/2/ (1,224,417) (1,145,927) (1,166,939)
21 Services/3/ (218,503) (210,385) (240,467)
29 Income payments (331,215) (269,389) (256,502)
30 Income payments on foreign-owned assets in the United States
(323,005) (260,850) (247,601)
31 Direct investment payments (60,815) (23,401) (50,121)
32 Other private payments (179,217) (156,784) (124,542)
33 U.S. Government payments (82,973) (80,665) (72,938)
34 Compensation of employees (8,210) (8,539) (8,901)
35 Unilateral current transfers, net (53,442) (49,463) (56,023)
36 U.S. Government grants/4/ (16,821) (11,628) (16,914)
37 U.S. Government pensions and other transfers (4,705) (5,798) (5,131)
38 Private remittances and other transfers/6/ (31,916) (32,037) (33,978)
 Capital and financial account
Capital account
39 Capital account transactions, net 837 826 708
Financial account
40 U.S.-owned assets abroad, net (increase/financial outflow (-)) (606,489) (370,962) (156,169)
41 U.S. official reserve assets, net (290) (4,911) (3,681)
46 U.S. Government assets, other than official reserve assets, net (941) (486) 379
47 U.S. credits and other long-term assets (5,182) (4,431) (5,213)
48 Repayments on U.S. credits and other long-term assets/8/ 4,265 3,873 5,696
49 U.S. foreign currency holdings and U.S. short-term assets, net (24) 72 (104)
50 U.S. private assets, net (605,258) (365,565) (152,867)
55 Foreign-owned assets in the United States, net (increase/financial 1,015,986
inflow (+))752,806 630,364
56 Foreign official assets in the United States, net 37,640 5,224 96,630
57 U.S. Government securities 30,676 31,665 74,013
58 U.S. Treasury securities/9/ (10,233) 10,745 43,656
59 Other/10/ 40,909 20,920 30,357
60 Other U.S. Government liabilities/11/ (1,909) (1,882) 158
61 U.S. liabilities reported by U.S. banks, not included elsewhere 5,746 (30,278) 18,831
62 Other foreign official assets/12/ 3,127 5,719 3,628
63 Other foreign assets in the United States, net 978,346 747,582 533,734
64 Direct investment 307,747 130,796 30,114
65 U.S. Treasury securities (76,965) (7,670) 53,155
66 U.S. securities other than U.S. Treasury securities 455,213 407,653 284,611
67 U.S. currency 1,129 23,783 21,513
68 U.S. liabilities to unaffiliated foreigners reported by U.S. nonbanking
174,251concerns 82,353 49,736
69 U.S. liabilities reported by U.S. banks, not included elsewhere 116,971 110,667 94,605
70 Statistical discrepancy (sum of above items with sign reversed) 7 10,701 28,524
70a Of which: Seasonal adjustment discrepancy ..... ..... .....
 Memoranda

Line (Credits +; debits -)/1/ 2000 2001 2002/p/

71 Balance on goods (lines 3 and 20) (452,423) (427,165) (484,353)
72 Balance on services (lines 4 and 21) 73,742 68,875 48,811
73 Balance on goods and services (lines 2 and 19) (378,681) (358,290) (435,542)
74 Balance on income (lines 12 and 29) 21,782 14,382 (11,862)
75 Unilateral current transfers, net (line 35) (53,442) (49,463) (56,023)
76 Balance on current account (lines 1, 18, and 35 or lines 73, 74, and
(410,341)
75)/13/ (393,371) (503,427)
 Int’l Investment Position
 In order to buy U.S. assets foreigners need
dollars, so net capital inflows represent a
demand for dollars.
 The demand for dollars comes from the demand
to buy goods and services and the demand to
buy (capital) assets.
 In the 1980s, the inflow of capital into the
U.S. greatly exceeded the outflow of capital
from the U.S., and this trend has continued
into the late 1990s. (KA > 0, CA < 0)
 Int’l Investment Position (continued)
 International Investment Position (IIP) is
another related balance sheet. It is a statement
of the stocks of a nation’s international assets
and foreign liabilities at a point in time, usually
the end of a year.
 Any capital flows (related to a current account
imbalance) creates a change in the IIP.
 Int’l Investment Position (continued)
 We say that a nation is a lender or a borrower
depending on whether its current account is
in surplus or deficit during a time period.
 We say that a nation is a creditor or debtor
depending on whether its net stock of foreign
assets is positive or negative.
 The first refers to flows over time, the second
to stocks at a point in time.
 Int’l Investment Position (continued)
 Prior to WWI, the U.S. was a net debtor.
 From WWI through 1983, the U.S. was a net
creditor (the world’s leading creditor).
 Since 1983, the U.S. has run large current
account deficits, requiring int’l borrowing.
 By 1989, the U.S. was a net debtor, and
continues to be so until the present.
 Difference between BOP and
BOT
 Balance of payments records all international inflows and outflows of funds to and
from foreign countries. The balance of trade is a component of the balance of
payments and is recorded under one of the main components of the balance of
payments; the current account.
 While the balance of trade shows only the difference between the value of a
country’s total imports and exports of goods and services, the balance of payments
shows an overall view of the country’s financial status by taking into consideration
transfers of capital, transfers of assets and funds, international investments, sales and
purchases of assets, remittances, gifts, unilateral transfers, changes in reserves, etc.
 The balance of trade is narrower in scope as it does not take into consideration the
capital and financial transactions. The balance of payments, on the other hand, is
more comprehensive as it covers all international transactions and, therefore, offers a
true and fair view of country’s financial status and economic performance.
EXCHANGE RATE
DETERMINATION
 FOREIGN EXCHANGE
 Popularly referred to as "FOREX"
 The conversion of one country's currency into
that of another.
 It is the minimum number of units of one
countries currency required to purchase one
unit of the other countries currency.
 WHY IT NEEDED???.....
 Different countries have different currencies
with different values….
Example: India - Rupees
America -Dollar
China - Yuan
 When trade takes place…..
the persons of these countries have to
convert their currencies to other countries
currencies to make payments
 For this purpose the concept of foreign
exchange come into operation.
 Under mechanism of international payments,
the currency of a country is converted in to the
currency of another country through
FOREIGN EXCHANGE MARKET.
 The effect of globalization and international
trade
 Increased import and export
 FOREIGN EXCHANGE
MARKET
 Also called “FOREX” market.
 It is the place were foreign moneys were
bought and sold.
 It involves the buying of one currency and
selling of another currency simultaneously.
• Exchange rates are determined here….
• Has no geographical boundaries…..
 FOREIGN EXCHANGE RATE
 It is the rate at which one currency will be
exchanged for another in foreign exchange.
 It is also regarded as the value of one
country’s currency in terms of another
currency.
There are three basic types;
Fixed rate
Floating rate
Managed rate
 FIXED EXCHANGE RATE
 It is the system of following a fixed rate for
converting currencies.
 In this system, the government (or the central
bank acting on its behalf) intervenes in the
currency market in order to keep the exchange
rate close to a fixed target.
 It does not allow major fluctuations from the
central rate.
 Advantages
 It provide the stability of exchange rate.

 Fixed rates provide greater certainty for

exporters and importers.

Disadvantages
 Too rigid to take care of major upheavals.

 Need large reserves to defend the fixed

exchange rate.
 May cause destabilizing speculations; most
currency crisis took place under a fixed
exchange system.
 FLOATING/FLEXIBLE
EXCHANGE RATE
 Under the flexible exchange rate system, the
rate of exchange is allowed to vary to suit the
economic policies of the government.
 Flexible exchange rates are exchange rates,
which fluctuate according to market forces.
 The value of the currency is determined solely
by the forces of demand and supply in the
exchange market.(self correcting mechanism)
 Advantages

 Automatic adjustment for countries with a

large balance of payments deficit.
 Flexibility in determining interest rates
 Allow countries to maintain independent
economic policies.
 Permit a smooth adjustment to external
shocks.
 Don't need to maintain large international
reserves.
Disadvantages
 Flexible exchange rates are highly unstable so
that flows of foreign trade and investment may
be discouraged.
 They are inherently inflationary.
 MANAGED EXCHANGE RATE
 Managed exchange rate systems permit the
government to place some influence on an
exchange rate that would otherwise be freely
floating.
 Managed means the exchange rate system has
attributes of both systems.
 Through such official interventions it is
possible to manage both fixed and floating
exchange rates.
 Simple Mechanism of Demand &
Supply
 As stated earlier exchange rate is determined
by its the forces of supply and demand.
 Therefore, if for some reason people increase
their demand for a specific currency, then the
price will rise provided that the supply remains
stable.
 On the contrary, if the supply is increased the
price will decline and it is provided that the
demand remains stable.
Purchasing Power Parity Theory (PPP
Theory)
 Most widely accepted theory
“According to PPP theory, when exchange rates
are of a fluctuating nature, the rate of exchange
between two currencies in the long run will be
fixed by their respective purchasing powers in
their own nations.”

 i.e the price of a good that is charged in one

country should be equal to the one charged for the
same good in another country, being exchanged at
the current rate.
 This rule is also known as the law of one price.
 It is an economic theory that estimates the
amount of adjustment needed on the exchange
rate between countries in order for the
exchange to be equivalent to each
currency's purchasing power.
 The Balance of Payment Theory
 The balance of payments approach is another
method that explains what the factors are that
determine the supply and demand curves of a
country’s currency.
 As it is known from macroeconomics, the balance
of payments is a method of recording all the
international monetary transactions of a country
during a specific period of time.
 The transactions recorded are divided into four
categories: the current account transactions, the
capital account transactions, financial account and
the central bank transaction.
 CURRENT ACCOUNT

export and import of goods &services

CAPITAL ACCOUNT

Capital transfers
FINANCIAL TRANSFERS

Foreign direct investment

Portfolio investment
RESERVEBANK TRANSACTIONS
 According to the theory, a deficit in the balance of
payments leads to fall or depreciation in the rate of
exchange, while a surplus in the balance of payments
strengthens the foreign exchange reserves, causing an
appreciation in the price of home currency in terms of
foreign currency. A deficit balance of payments of a
country implies that demand for foreign exchange is
exceeding its supply.
 As a result, the price of foreign money in terms of
domestic currency must rise, i.e., the exchange rate of
domestic currency must fall. On the other hand, a
surplus in the balance of payments of the country
implies a greater demand for home currency in a
foreign country than the available supply. As a result,
the price of home currency in terms of foreign money
rises, i.e., the rate of exchange improves.
 DETERMINANTS OF FOREIGN
EXCHANGE RATE

1. Interest Rate
Whenever there is an increase interest rates in domestic
market there will be increase investment funds causing a
decrease in demand for foreign currency and an increase in
supply of foreign currency.
2. Inflation Rate
when inflation increases there will be less demand for
local goods (decreased supply of foreign currency) and more
demand for foreign goods (increased demand for foreign
currency).
3. Government budget deficit or surplus
The market usually react negatively to widening
govt. budget deficits and positively to narrowing
budget deficits. This will result in change in the
value of countries currency.
4. Political conditions
Internal, regional and international political
conditions and events can have a profound effect on
currency market